House of Commons - The Kay Review of UK Equity Markets and Long-Term Decision Making - Business, Innovation and Skills Committee

The Kay Review of UK Equity Markets and Long-Term Decision Making - Business, Innovation and Skills Committee Contents

4 Professor Kay's recommendations and implementation

Investors Forum

15. Professor Kay recommended:

He elaborated that he saw the Forum as an opportunity for collective action to help "improve the performance of a company". He concluded that "the more opportunity there is for people who collectively own 30, 40 or 50 per cent of the company to act together, the more offset we have against that particular freerider issue".[22]

In its response to the Review, the Government accepted this recommendation:

16. Daniel Godfrey, of the Investment Management Association, told us that the Forum could produce benefits in terms of sharing stewardship resources and combating over-diversification of portfolios:

17. BlackRock, which was in favour of the Forum in principle, outlined three challenges and principles that should be put in place alongside the Forum to ensure its success:

1. The new forum needs to cover topics/issues that go beyond the typical discussions currently conducted through the existing industry.

2. The forum's governance policies need to ensure confidentiality of the meetings and views expressed as this aspect will be the key determining factor of the forum's effectiveness and ultimate success.

18. A number of our witnesses saw practical difficulties in creating a successful Forum. Despite the positives noises from the Investment Management Association, several witnesses argued that there was no need for the Forum, as there were already other investor groups in place. For example, FairPensions (now ShareAction) told us that "it is unclear how this initiative will differ from previous and existing investor bodies, such as the Institutional Shareholders Committee".[26]

19. Standard and Chartered Bank argued for a cautious approach in setting the remit for any new Investor Forum:

The Association of General Counsel and Company Secretaries of the FTSE 100 also took a sceptical view, arguing that there was "nothing to prevent interested parties from establishing such forums now, which leads us to question whether there is really a need for this type of body".[28]

20. Neil Woodford questioned whether asset managers would take part in such a Forum:

Furthermore, Chris Hitchen, of USS Investment, pointed out to us that investment managers were "scared to meet, because the FSA or Takeover Panel might be suspicious".[30] Steve Waygood, from Aviva Investors, told us that collaboration of investors through a forum would not necessarily produce results, and would need monitoring and proper resource:

21. Albion Ventures LLP argued that individual shareholders should not be given a collectivised voice as it believed that "solidarity amongst investors was unnecessary and may even weaken the strength of the shareholder system, namely that shareholders vote and act as individuals".[32] This opinion was disputed, however, by Christine Berry of FairPensions (now ShareAction) who told us that any Investor Forum "would need to include representation from asset owners as well as asset managers".[33] She went on to argue that it must not become "just another vehicle dominated and run by the trade associations, which would be very similar to the vehicles we already have".[34] Lord Myners shared this view, and clearly told us that if the Forum became "dominated by trade associations" then it would undermine the whole purpose behind the Review, because "trade associations' modus operandi is to protect the status quo. It is not to change things".[35]

22. Penny Shepherd, Chief Executive of the UK Sustainable Investment and Finance Association (UKSIF), set out the three key groups which needed to be involved:

Active managers of equities

Engagement specialists

Asset owners

23. When we questioned the Secretary of State on the role and remit of the Forum and how it would counter the risks illustrated by the industry, he gave a hands-off response:

He went on to tell us that this approach also extended to funding:

24. The IMA, alongside the Association of British Insurers and the National Association of Pension Funds, have accepted the challenge to establish the Investor Forum. They have stated that the next stage of implementation is to set up a working group to consider practicalities and issues surrounding the Forum, which would report later this year:

25. The IMA has confirmed that this timetable stands and that the working group will report its findings by the end of November 2013.[40] We received evidence expressing frustration that this seemingly simple and specific recommendation had not been implemented so long after it was accepted. Lord Myners told us that:

26. We put the criticism to the Secretary of State that, despite the recommendation being accepted in the Autumn of 2012, the Forum remained in concept form only. The Secretary of State conceded that that was "a fair criticism",[42] but gave the following warning:

27. We agree with Professor Kay and the Government that collective engagement is to the benefit of the equity market and UK businesses. However, we are concerned that the hands-off approach taken by the Government runs the risk that progress will stall. The Government has provided no remit, deadline or resource for the Investor's Forum and the 'working group' to investigate the concept of the Investor's Forum will not report until later in 2013. The Government has told us that it will publish an update on progress in the summer of 2014. We recommend that the Government outlines a clear timetable for setting up the Forum before that point, engaging with different types of investors, along with milestones and assigned responsibilities for achieving this.

Fiduciary duty

28. Professor Kay summarised his analysis on the topic of fiduciary duty and his interpretation of its current definition in the following terms:

However, he believed that a greater focus needed to be placed on the principles of loyalty and prudence, rather than the technical legal interpretation as it stood:

29. Professor Kay went on to outline his expectations for a new definition. He told us that he had two minimum expectations. Firstly:

That anyone who is engaged, either in advice or in discretionary activity of some kind, accepts the obligation to put the client's interests first, ahead of his or her own.

With respect to fiduciary duty, Professor Kay recommended that the Law Commission should "review the legal concept of fiduciary duty as applied to investment to address uncertainties and misunderstandings on the part of trustees and their advisers".[47]

30. The Government accepted this recommendation and the Law Commission has taken on the project:

In broad terms [the Government] ask us to set out what the current law requires pension trustees, investment managers and other financial intermediaries to consider in deciding an investment strategy. In particular, do fiduciary duties apply to all those in the investment chain? And how far must fiduciaries focus exclusively on maximising financial return, to the exclusion of other factors?

We are not asked to look at the law in isolation. Instead, the project will consult stakeholders about their understating of the law and how it impacts on them.

31. Christine Berry, Head of Policy and Research at FairPensions (now ShareAction), was "supportive" of the Law Commission's work to clarify the definition, but she stressed that "we should not assume that at the end of the process it will be sufficient just for the Law Commission to pronounce that "this is what we think the law is", and it will change behaviour".[49]

32. The Law Commission has announced that it "will publish a consultation paper by October 2013".[50] After analysing the responses, it plans to "publish a final report with our recommendations by June 2014".[51] We were concerned that the timetable lacked any urgency.

33. Tomorrow's Company told us that "fiduciary duty is not well understood by pension fund trustees and needs to be appropriately and more widely interpreted".[52] The Investment Management Association told us that "asking the Law Commission to undertake such a review will mean that it will be subject to an open and transparent consultation process".[53] However, it went on to warn us that "fiduciary principles at law may not be capable of exact definition".[54] BlackRock, on the other hand, rejected Professor Kay's findings and told us that the rules around fiduciary duty were "sufficiently well understood under English law":

34. We also heard evidence that the lack of clarification is having a material impact on the stewardship of firms and the investment behaviour (in terms of short or long-term outlook) of fund managers. FairPensions (now ShareAction) argued that this lack of clarity resulted in investment managers being discouraged from taking a long-term or progressive approach to the companies in which they invest and that this needed to change as a matter of urgency.[56]

35. When we questioned the Department, it told us that:

It went on to assure us that the Departments' expectation was that "the total costs for the current financial year will be in the region of £75,000".[58] The Secretary of State confirmed that he had not attached any timescale to the Law Commission's work:

However, he agreed that it was "frustrating" and "would much rather we had some quick results with some of these things".[60]

36. The Law Commission is currently consulting on the legal definition of fiduciary duty and will not report back until June 2014. We believe that this is too slow. We recommend that the Government liaises with the Law Commission to bring forward the timing of this project. The Government is paying up to £140,000 for this project and we expect it to push for the highest value for the taxpayer's money. The Law Commission will launch a three month consultation in October 2013. We suggest that it gives this issue the appropriate priority and publishes its final definition in the first quarter of 2014.

Appointment of executives

37. Professor Kay recommended that:

In making this recommendation, Professor Kay said that it was targeted at "major board appointments" and that for smaller companies "it would probably be primarily about the chairman and chief executive".[62]

He also clarified that he would apply this recommendation to the "six to 10 large asset managers who are now speaking for a very large proportion of UK equities".[63] The Government accepted this recommendation:

It went on to connect this recommendation to the Investor's Forum:

38. Several witnesses indicated that this recommendation was unnecessary as the practice already took place. Aberdeen Asset Management plc told us that it already held "regular meetings with management and board members to discuss strategic, operational, risk and governance matters".[66] As an investor, it aimed to visit companies at least once a year "but, in practice, it is often at least twice annually".[67] The Investment Management Association told us that many asset managers were already specifically consulted on major board appointments:

39. Other asset managers, however, corroborated Professor Kay's view that "asset managers would say that they did not really have the expertise to do this".[69] Neil Woodford confirmed that he did not feel that the role of the fund manager was "to tell companies how to run their businesses".[70] He took the argument a stage further by telling us that Professor Kay's recommendation would actually damage performance and that "boards would become dysfunctional if all their fund managers were trying to chip in and tell them how to run their business".[71] Lord Myners concurred. He questioned why asset managers should be consulted on such decisions, given that they had no business experience:

Professor Kay acknowledged this concern but expressed his hope that, over time, asset managers would gain the expertise to carry out this objective.[73]

40. Other witnesses told us that, qualified or not, fund managers would not want to be involved in these decisions because it would mean becoming an 'insider' which could create a conflict of interest. This would restrict such a manager from trading his or her shares. To us, this is an illustration of the dysfunctional relationship created by the role of asset managers. The fact that managers represent the owners of shares but do not want to take responsibility for the ownership of the companies summarises the heart of the issue. The Association of General Counsel and Company Secretaries of the FTSE 100 summarised the problem:

41. Lord Myners characterised institutional investors as saying "we don't like being made insiders" because "we don't like to give up our right to deal".[75] Lord Myners expressed dissatisfaction that this was the case but told us that as it stands, Professor Kay's recommendation was simply not practical:

42. Albion Ventures took a different view. It told us that consultation of major shareholders was a start, but that Professor Kay had not gone far enough. It recommended that "long-term substantial shareholders should have representation on the boards of companies in which they invest".[77] It argued that this would "allow longstanding investors to have personal, reciprocal and trust-based relationships with the company management".[78] We asked Harlan Zimmerman, Senior Partner at Cevian Capital, how the current appointment system could be improved and how external forces should influence the decision. He told us that it was not necessary for shareholders to be represented on the boards of companies because the non-executive directors were supposed to be fulfilling that role. However, he went on to explain that the role of non-executive directors had been ignored and described the fact that this was overlooked by Professor Kay as being "the single biggest problem" with the Review:

Fidelity, even with the best will in the world, cannot look after the day-to-day operations of thousands of companies, so we have nonexecutive directors who are there, who are supposed to be doing that job for us.

43. Professor Kay has provided a clear recommendation, proposing that companies consult with major investors over all board appointments and the Government has agreed to implement this. We therefore recommend that the Government publishes a timetable for the implementation of this policy, clarifies which investors companies are to consult with and outlines how it intends to combat the issues surrounding insider trading and confidentiality which inevitably accompany such board appointments. Alongside this, the Government should undertake an impact assessment, particularly looking at the possible increase of bureaucratic burdens on small businesses and, if necessary, introduce an opt-out clause for them.

Remuneration of executives

44. Professor Kay recommended:

When he spoke to us, he outlined his vision for the principles underlying this recommendation:

45. The Government accepted the principle behind the recommendation but not any specific role in its implementation. It did, however, refer to work it was already undertaking to reform the governance processes behind executive pay:

46. The Government was also positive in its support of Professor Kay's ideas for performance incentives to come in the form of shares which would be held until the executive had left. However it stopped short of implementing this recommendation, instead stating that this could be achieved through "good practice" rather than through state intervention:

47. We received a significant body of evidence on this recommendation. The National Association of Pension Funds Limited agreed with Professor Kay that "the best form of alignment between executives and shareholders is the ownership of shares over the long-term".[84] Lord Myners agreed with the recommendation in principle, but cautioned us that it may not work in practice:

He concluded that "a director can actually have too much of their wealth invested in the company. They become too obsessed with the share price".[86] The Investment Management Association suggested a compromise to encourage positive behaviour though incentives. While they agreed with Lord Myners that requiring executives to hold the shares until after they had retired "could result in them leaving a company when they consider it the best time to realise those shares",[87] they went on to assert that:

The IMA recommended that the current system used by many companies could be tweaked without the need for a change in regulation or austere shareholding requirements:

48. Several of our witnesses agreed that, while shares were an effective way to connect executive pay to company performance, Professor Kay's recommendation was something of a blunt tool. For example the Chartered Institute of Personnel and Development (CIPD) told us that the "focus on financial gain to the exclusion of other considerations has played a large part in distorting views of businesses' purpose" and that performance should go "beyond the purely financial and how much profit is being generated":

49. Other experts agreed with the Government that there was no case for blanket regulation in this area. The Association of General Counsel and Company Secretaries of the FTSE 100 stressed that any change to the executive pay regime had to preserve an element of flexibility. It withheld support for Professor Kay's recommendation and concluded that there could never be a "one size fits all" policy to achieve this.[91] It wrote to us with four arguments against the compulsory implementation of Professor Kay's recommendation:

1. Such a policy is likely to make it considerably harder to attract good candidates. This is likely to be a particular issue for the many London-listed companies which have some or all of their operations and/or directors located outside the UK.

2. Directors have come to rely on the performance related pay and deferral for the length of time envisaged by the Recommendation may be impractical.

3. Such a policy may simply shift the emphasis from performance related pay to basic pay which could possibly mean that there is less incentive for management to pursue performance enhancing strategies.

50. Standard Chartered Bank also argued that Professor Kay's recommendation would distort the market and damage the leadership of British firms:

51. By contrast, the UK Sustainable Investment and Finance Association expressed frustration that the Government had not fully accepted this recommendation and that the Government had "yet to facilitate a deep and constructive debate specifically on incentives and pay within the investment chain".[94] We asked Professor Kay to comment on the Government response to this recommendation. He too expressed regret that his recommendation had apparently been sidestepped, and asserted that, because "people frequently do specific things they are incentivised to do", the current system of executive pay was incentivising the wrong behaviour and needed to change.[95] He believed that there was an argument for his recommendation to have been made compulsory.[96]

52. The Government has accepted the principles underlying Professor Kay's recommendation on the remuneration of executives. We are therefore disappointed that it has failed to take the action to see it put into practice or responsibility for its implementation. We are not persuaded by the Government's view that businesses will see the benefit of this recommendation and will adopt this measure voluntarily.

53. We support the recommendation that company directors should be tied into the long-term performance of their companies through time-appropriate shares. Since the Government has accepted Professor Kay's analysis and agreed with his findings, it should reconsider its response and take an active approach to its implementation. In particular, we recommend that the Government outlines how it intends to combat the issue of directors using options and derivatives to avoid these rules. Alongside this the Government should outline how it will ensure that departing directors will not be perversely incentivised to artificially inflate the share price immediately prior to their retirement or retire early to realise the locked-in value of their shares.

Incentivising fund managers

54. Professor Kay recommended:

55. The Government accepted the principles underlying this recommendation:

56. With regard to current remuneration practices, Russell Investments agreed with Professor Kay's analysis. It stated that a short-term focus was "encouraged by the business models of asset managers who are generally incentivised to maximise the volume of assets they gather rather than focus on good, long-term outcomes for their investors".[99] It went on to tell us that owners tended to follow fashionable managers:

100

57. The Investment Management Association took this further and told us that owners were not overly concerned with the remuneration of the managers they instructed because they were paid by the asset management firm, not by the client directly:

101

It went on to warn us that too strict aligning of the performance of a manager's fund and remuneration "could encourage a portfolio manager to leave at a time when their particular fund is performing well for clients".[102]

58. BlackRock was keen to highlight the fact that the current system of remuneration of asset managers often had performance incorporated. It told us that, for its managers, "compensation reflects investment performance over the short, medium and long-term and the success of the business or product area".[103] It went on to explain that "a limited number of investment professionals have a portion of their annual discretionary awarded as deferred cash that notionally tracks investment in selected products managed by the employee",[104] but it warned us that this could not be rolled out more widely because of global regulation:

105

Neil Woodford, Head of UK Equities in Invesco Perpetual, believed that incentive structures were "really important around performance measurement and the hiring and firing of fund managers".[106] It recommended that changing those structures to a longer term perspective would be "a very important step in encouraging longer term behaviour and more engagement".[107] Chris Hitchen, Chief Executive of RailPen, agreed. He drew on his experience in the pension industry to elaborate on how the definition of success for fund managers needed to be changed:

108

59. Other witnesses brought up the issue of 'tracking-error'. Dominic Rossi, Global Chief Investment Officer at Fidelity Worldwide, explained that "tracking error is a statistically based measure of the likely deviation of returns of the portfolio versus the specified benchmark".[109] It is often used as a measure of success when investors chose which fund managers to trust their capital with. While it may be appealing to have some measureable way of tracking performance, Lord Myners explained that this was a somewhat blunt tool:

110

Other witnesses told us that tracking error was partially responsible for the over diversification of portfolios. Harlan Zimmerman, Senior Partner at Cevian Capital, summarised this argument:

111

Lord Myners asserted that the industry was aware that current measures of performance simply did not give fund managers enough confidence to invest over the long-term for fear of appearing deficient compared to the short-term benchmark:

112

60. It was generally agreed that even when fund manager remuneration was linked to some measure of performance, the measure of performance was often short-term and set against inappropriate benchmarks. FairPensions (now ShareAction) wrote to us to summarise its research and proposed eight steps to align the incentives of investors and fund managers to the more long-term:

· Fund manager performance should be reviewed over longer time horizons than the typical quarterly cycle.

· Excessive reliance on measuring performance relative to a market index should be reduced.

· Pension funds should have voting and engagement policies that should be integrated into the investment process.

· Shareowner activism should be given more weight in the selection and retention of fund managers and other matters.

· All advisors to institutional investors should have a duty to proactively raise ESG issues and encourage adherence to the Stewardship Code.

· Fund management contracts and fund managers' performance should include an evaluation of long-term ability to beat benchmarks.

· Investment consultants' fee structures should not reward them for moving clients between fund managers.

· Within companies the implementation of strong cultural norms should be supported by independent whistleblowing mechanisms, overseen by professional bodies who offer the whistleblower appropriate protection.[113]

Catherine Howarth, The Chief Executive Officer for FairPensions (now ShareAction) did temper this evidence with a call for simplicity:

114

61. The Government has promised to "encourage asset managers to adopt such models [incorporating performance measures into the remuneration of fund managers] by promoting consideration of the Kay Good Practice Statement for Asset Managers".[115] However, it is not clear whether the Government is taking an active or passive role in this change.

62. The incentives driving the actions of fund managers are one of the most important factors within the investment chain. Professor Kay made a specific recommendation on this but the Government has shied away from accepting it, citing an unwillingness to prescribe pay structures. While this may be understandable, it is clear that the Government must be involved; at the very least encouraging a cultural shift away from short-term to long-term performance-based pay.

63. We recommend that the Government takes a harder line when framing the culture in which fund managers work by highlighting best practice where it sees it. We further recommend that it should work towards the goal that fund manager performance be reviewed over longer time horizons than the typical quarterly cycle.

64. One way that the Government can help effect a culture change in the incentives driving fund-manager behaviour is to develop and publish a set of long-term measures of success alongside options for sanctions for demonstrable failure. We recommend that it does so, and then annually publishes a list of those firms that have fully adopted such measures. This would provide a different measure of success to the very short-term ones which are currently available.

Quarterly Reporting

65. In respect to company reporting, Professor Kay made two recommendations:

i. Companies should seek to disengage from the process of managing short-term earnings expectations and announcements;[116] and

ii. Mandatory IMS (quarterly reporting) obligations should be removed.[117]

The Government accepted both recommendations and went on to clarify that, since the Kay Review had been commissioned, the European Commission had brought forward proposals to amend the Transparency Directive. Implementation of the recommendation removing quarterly reporting obligations would, therefore, be dependent of the successful passing of the amendment and upon negotiation with the EU:

118

The initial assurances that the Government had apparently fully backed Professor Kay on this recommendation were somewhat dampened, however, when we read further down the government response. In that response, the Government went on to say that once the EU directive had been amended, any change would then depend on further consultation:

119

66. Professor Kay told us that he had clarified his analysis behind the recommendation. He began by asserting that the idea that more information was always better was "not true".[120] He found that "companies produce steady streams of reported quarterly earnings" which served to encourage those involved to think only from one quarter to another which potentially damaged the long-term performance of firms.[121] He concluded that this should be replaced by "more qualitative relationships between the company and the asset manager".[122] Aviva plc took a similar view:

123

67. Other experts agreed that the process of producing short-term (quarterly) reports had had a behavioural effect on the managers and investors both producing and reading them. BlackRock explained that:

124

The Chartered Institute of Personnel and Development also believed that reporting on a quarterly basis may have acted as "a contributory factor to a short-term outlook on company performance".[125]

68. By contrast, Albion Ventures did not believe that quarterly reporting was at the heart of the problem:

126

It went on to explain that it was not the frequency of such reports that was the problem, but the content and that current reporting practices did not focus on the correct information. Specifically, companies should steer away from "marketing speak" and move towards "something much more balanced, objective and long-term minded".[127] Dr Woolley, Head of the Paul Woolley Centre for the Study of Capital Market Dysfunctionality, also argued that there was "no merit" in reducing the flow of information and told us that "the quarterly reporting of pension fund returns should still go on".[128]

69. Finally, we were warned by the Association of General Counsel and Company Secretaries of the FTSE 100 that any changes in the UK (or Europe for that matter) will have a diminished effect because of the global nature of reporting standards:

129

70. We support Professor Kay's recommendation that the requirement for quarterly reporting should be removed and recommend that the Government now outlines a clear timetable to implement this recommendation including what alternative strategies would be followed in the absence of any change in EU law.

71. We recommend that the Government sets out details of progress in negotiations with other international accounting standard bodies (such as the U.S. Securities and Exchange Commission) on the requirement for quarterly reporting to ensure that any changes made to the domestic or EU-wide accounting practices are accepted on a global level.

Narrative Reporting

72. Professor Kay recommended:

130

The Government accepted this recommendation:

131

The Government has stated that it will introduce regulations to "bring about the changes to the structure and format of reporting" and the intention is for these to come into effect by October 2013.[132] The Government, in its response to the Review, went on to say that it would be "working closely with the Financial Reporting Council (FRC) as they develop the guidance on the new provisions".[133]

73. Professor Kay concluded that good reporting went against the instinct of most company directors:

134

Daniel Godfrey, Chief Executive of the Investment Management Association, agreed:

135

74. Lord Myners agreed, but took the issue further and told us that irrelevant information or an absence of information was less serious than misleading data. In particular, he agreed with Professor Kay's recommendation for narrative reporting:

136

75. Tomorrow's Company warned that, while they "strongly welcome" the recommendation and had "long argued" for such a change in regulation there was a "danger of overload".[137] It told us that this was because there were so many regulatory and market initiatives, changes and consultations throughout the world which focused on different aspects of reporting:

138

76. The Association of General Counsel and Company Secretaries agreed, stating that "it will be important to ensure that there is a 'joined-up' approach between all legislative and regulatory bodies".[139] It took this further and told us that domestic reporting standards would be ultimately ineffective when held against the reporting requirements of other countries'. It concluded that "any streamlining of the UK position would be undermined by US regulation which, generally, requires more detailed reporting".[140]

77. Lord Myners, however, did not consider narrative reporting to be an onerous burden:

141

78. We recommend that the Government sets out how it will ensure that enhanced narrative reporting will remain consistent with, and accepted by, overseas regulators, for example the US Securities and Exchange Commission.

79. When the proposed changes are made to the structure and format of reporting, the Government (through the Financial Reporting Council) will need to ensure that any accompanying guidance on the new provisions included clear minimum standards to ensure comparability. The Government must not shy away from strict enforcement of these standards. The scrutiny and consistency of narrative reports may be harder than that of reports containing only information about pounds and pence, but the Government must ensure high standards are maintained. We therefore recommend that the Government outlines how it proposes to implement auditing and monitoring of narrative reports. Ongoing shareholder scrutiny and transparency must be at the heart of this. These processes must be in place before the proposed changes come into effect.

21 Professor Kay, The Kay Review of UK equity markets and long-term decision making, July 2012, page 51, rec 3 Back

22 Q 30 Back

23 Department for Business, Innovation and Skills, Ensuring equity markets support long-term growth: The government response to the Kay Review, November 2012, para 3.18 Back

24 Q 281 Back

25 Ev 129 Back

26 Ev 112 Back

27 Ev 88 Back

28 Ev 116 Back

29 Q 244 Back

30 Q 244 Back

31 Q 246 Back

32 Ev 91 Back